Over the past few weeks, I have watched with some interest the startup community’s response to National Treasury’s announcement that the Section 12J tax incentive will not be renewed come the scheme’s original deadline of 30 June 2021.
The scheme essentially gave individuals and companies a full tax deduction for all amounts invested in via what it defined as approved Venture Capital Companies, who would in turn invest these monies into qualifying SMEs. For example, if an individual at the highest bracket invested R1 million with such a VCC, he would essentially get 45% of this investment – or R450,000 - back immediately. But like all things with good intentions, many shrewd, opportunistic, and mostly wealthy people found loopholes to invest in all sorts of things including property developments and asset leasebacks, while still getting this tax break. This de-risked and undermined the impact of the tax incentive and some bright spark at National Treasury decided we can the whole thing.
“The intention and spirit of the Section 12J incentive was always to overcome one of the main challenges to the economic growth of South African SMEs: access to equity finance - by making the VC asset class accessible for retail investors. Unfortunately, only a handful of VCCs have investment mandates to legitimately claim that they invest in SMEs. If there were more of these VCCs out there focused on SMEs, I believe that this would have been a permanent incentive for the benefit of the ecosystem driving innovation, job creation and economic growth” – says Keet van Zyl, co-founder of leading VC firm Knife Capital.
So, if the problem was the mandates of the VCC’s, then why did government not keep the incentive, but introduce new rules that would curb its abuse and more narrowly define what makes for a qualifying SME investment. At least this way, the good guys can keep benefiting from the incentive, and the deserving small businesses can get access to the equity.
“The first few years of the incentive were lost as it did not take off. After inputs from SiMODiSA, SAVCA and others, the incentive was tweaked, and it started gaining momentum. But investing in SMEs has a lag time because first money needs to be raised, then deployed, and then startups need time to reach scale. The incentive should have been adapted and aligned to the original intent long ago. The June 2021 sunset clause should have been extended with refinement of the ‘qualifying investee’ definition to stamp out abuse and encourage and force VCCs to stick to the spirit & intent of the tax incentive. Why would you not continue to back the 37% of SME Qualifying Companies that created jobs post investment?” – says Van Zyl.
Well at least for fund managers like Knife Capital, this doesn’t mean the end of the road. The move will definitely hamper their fund raising efforts in the medium term, but they are “a VC Fund Manager first and a 12J VCC second” says Van Zyl. The firm recently raised another $10 million dollars from Black-Owned investment firm, Mineworkers Investment Company – a visionary move that could trigger a new source of capital in BEE investment firms being major investors in Venture Capital. But what about the eco-system that is so in need of early stage capital?
The South African business landscape has never been short of capital for good investments. In fact, the opposite has happened in the past, where companies with tons of capital sit on the cash in protest that government isn’t creating a conducive environment to deploy their capital, much to the annoyance of the politicians.
Availability of capital is not our problem. It’s allocation is the problem, especially when it comes to early stage venture capital.
If you look closely at the many funds that have been announced lately, more and more are looking for investments in the sweet spot between early stage VC and more traditional funding such as private equity. They are doing this because it makes business sense. Startups that have gone through the seed and series A rounds have already reduced risk to an acceptable level for a private investor.
However, in SA, that’s still too risky a stage, because banks and private equity players want profitable businesses with a track record before they invest. So, VC funds can pick up the investment from the early-stage investors – very often the Family, Friends and Fools or FFF’s – then help the businesses grow to a scale where a more traditional investor like a Private Equity firm or a global trade player would pick them up, hopefully a healthy return.
However, what happens to the startup that doesn’t have cash rich FFF’s? For me that is where the s12J incentive would’ve played a key role. Purely because of the size of the tax break, every investor is de-risked from day one, which means that one’s targeted internal rate of return is so much easier to reach, which in turn should make the investor have a lot more appetite for risk. This is not rocket science. Government got lazy here.
Someone in a position of power decided that it would be too much trouble to actually apply their minds to the changes that would achieve the strategic objectives originally intended by the s12J incentive. They perhaps, figured it would be just too hard to go back and look at how the wealthy tax dodgers abused the tax break. Or maybe it would be too much work to figure out the loopholes that need closing, then figure out how to close them. Or perhaps they figured that the lost tax revenues from the abuse of the scheme are not worth the economic growth and job creation we could get from funding SMEs. Or maybe they were just not interested in how the state could, for the first time in a long time, play a legitimate game-changing role in attracting early-stage funding for SMEs by using the lever of statute and taxes.
Whatever the reason for this odd decision, South Africa has thrown the baby out with the bathwater. This article was first posted on www.businesslive.co.za